Understanding the “Momentum Effect”

Often it’s safe to assume that what goes up must then come down. With investing, however, it’s not quite so simple. Studies have shown that stocks tend to have a “momentum effect,” meaning that stocks that have recently gone up are more likely to do well in the near future (and that stocks that have recently gone down are more likely to do poorly in the near future).

There are a few possible explanations for this phenomenon. One is that investors struggle to immediately digest new information, so it takes a while for good news or bad news about a company to be fully reflected in its stock price. Another explanation is that people tend to invest in funds that have done well recently, which also happen to be the funds that hold stocks that have done well. When new money flows into these funds, it further pushes up the prices of these stocks.

So should you start buying stocks that have recently gone up? Not so fast. There are high trading costs in any strategy that involves buying and selling a lot of stocks, and the momentum effect only applies in the short term (perhaps 3 to 12 months). Over longer periods of time, stocks that have done poorly in the past actually tend to do better.

Furthermore, there is evidence that while professional investors can effectively use momentum strategies, individual investors often don’t fare so well. Individual investors tend to take the idea too far, focusing only on the top-performing stocks (an “extreme momentum” strategy) rather than stocks that have merely done well.